In reversal, Washington seeks more financial regulation

WASHINGTON — After at least a quarter-century of pressing for deregulation of financial markets, economists and members of Congress are pushing for renewed regulation in hopes of heading off a collapse of the global banking system.

Federal Reserve Chairman Ben Bernanke on Tuesday became the latest official to call for additional government powers, saying that the Fed should be given more authority to determine how much cash investment banks are required to keep in reserve and to monitor how they manage the risk involved in their investments.

When the head of the Fed calls for greater financial regulation, echoing Treasury Secretary Henry Paulson, a former Wall Street titan, it's significant. It's also a repudiation of the long-held view that markets alone can best regulate themselves. Whether regulations will be successful is an open question.

"I think it is going to be a turn back towards more regulation, but it's not going to be so easy," said Barry Bosworth, a presidential adviser in the 1970s who's now a senior economics fellow at the Brookings Institution, a center-left research center. "I think they've got a dilemma that some of these new financial instruments, and markets, have become so complex. If they continue to let them operate, it’s not clear that the regulators will be able to keep up."

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Vincent Reinhart agrees. Until recently he was the chief economist of the Fed's interest rate-setting Open Market Committee. Reinhart, too, thinks that significantly stronger regulation is coming.

"I think it's quite possible that in the spring of next year, we will have the most significant re-regulation in memory, and I don't think it's (in the last) 25 years. I think it's 75 years, and you've got to go back to 1933” and the Great Depression, said Reinhart, who's now an analyst at the American Enterprise Institute, a conservative research center.

Bernanke signaled clear support for congressional and Bush administration efforts to bolster existing financial regulations when he spoke Tuesday to a Federal Deposit Insurance Corp. forum in suburban Washington. He supported expanded Fed powers to guard against system-wide shocks to global finance, but cautioned that his agency needs Congress to grant it explicit authority, which it now lacks.

"The financial turmoil since August underscores the need to find ways to make the financial system more resilient and stable," Bernanke said.

The recent collapse of investment bank Bear Stearns is driving the push for new regulation. The Fed was forced to step in on March 14 and, over a single weekend, broker the fire sale of Bear Stearns to rival JP Morgan Chase after investors began the modern-day equivalent of a run.

The Fed also agreed to provide emergency lending to investment banks, something it had not previously done. While the Fed has long been the lender of last resort to troubled commercial banks, which it regulates, it has no explicit authority to do so with investment banks, which it doesn't regulate.

Former Fed Chairman Paul Volcker has suggested that the Fed overstepped its authority, but Bernanke maintains that the move was legal because the Fed has broad responsibility to protect the U.S. financial system from collapse.

Since then Treasury Secretary Paulson, a former chairman and chief executive officer of investment bank Goldman Sachs & Co., has offered a blueprint for revamping the regulation of financial markets. He recently said that some of his proposals shouldn't wait.

On Thursday, the House Financial Services Committee will hold the first of several hearings on the state of financial market regulation and the safety and soundness of the banking system. Bernanke and Paulson are scheduled as the lead-off witnesses.

Before the hearings, Bernanke spelled out what he wants from Congress: a new, more robust framework for regulating investment banks, which aren't subject to supervision and capital requirements, unlike commercial banks.

The Securities and Exchange Commission has oversight of the holding companies that own investment banks, but the oversight is based on voluntary agreements with the banks.

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"Strong holding-company oversight is essential, and thus, in my view, the Congress should consider requiring consolidated supervision of those firms, providing the regulator the authority to set standards for capital, liquidity holdings and risk management," Bernanke said.

Investment banks also are deeply involved in trading complicated financial products called over-the-counter derivatives. These transactions are often are not recorded on a bank’s balance sheet, meaning they are often hidden from the attention of regulators.

This largely unregulated market is huge. The Bank of International Settlements estimates that as of June 2007 derivative deals were valued in excess of $500 trillion. For comparison, the entire U.S. economy produces about $14 trillion in goods and services each year.

The risk to the global banking system from derivatives became apparent during the sudden March meltdown of Bear Stearns. The Fed feared that allowing Bear Stearns to fail could lead to confusion over who owed what to whom in derivatives markets, sparking panic and a run on other investment banks and perhaps collapse in global financial markets.

In the months ahead, Congress will look at the trading in such complex instruments and try to determine where to regulate and perhaps what to prohibit.

"I think they are going to be forced openly to think about banning some of these instruments," economist Bosworth said. He said that forcing banks to disclose some of their investments may simply lead them to pull out of certain markets.

Reinhart, the former Fed economist, sees similar changes ahead.

"When you get into the whirlwind of regulation, it could involve rolling back some financial (instruments) I wouldn't rule out eliminating (some) financial instruments," said Reinhart.

Unlike his predecessors, who came from Wall Street and business backgrounds, Bernanke was a career academic. As Fed chairman, he hasn't dogmatically rejected government regulation. This at times has put him at odds with more conservative presidents of regional Federal Reserve banks.

One of them is Jeffrey Lacker, president of the Richmond Fed, which oversees banking and tracks economic activity from South Carolina to Delaware. Lacker has criticized the Fed's sale of Bear Stearns and its opening of the discount window to investment banks. After a speech Tuesday in Washington, when speaking to a handful of reporters, he favored letting financial markets self regulate.

"All of these entities are subject to market discipline to some extent or another we broadly have a system in which a huge swath of the financial system is regulated primarily by market discipline. I don't think we should give that up," Lacker said, warning against "bringing everything under the close scrutiny of a supervisory authority."